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Holding: ATW

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Symbol	Sector	Return	Exposure	Trades	Last Trade	Status
ATW	Oil Equipment and Services	187.08%	n/a	1	14-Oct-09	Prior Holding

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19-Jun-09

Calculate Maintenance Capital Expenditure in FCF

Holding Rationale for ATW.

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As you know, I try to approach stock analysis and business valuation with different methods in order to try and fill holes and weaknesses.

One aspect that I want to cover that I haven’t discussed before is regarding maintenance capital expenditures in Free Cash Flow (FCF) for the Discounted Cash Flow (DCF) valuation method.

Even now when it comes to FCF, I don’t worry about trying to calculate the exact details of maintenance capex, but going the extra mile to calculate maintenance capital expenditure will surely put you ahead of everyone else when it comes to uncovering hidden value.

Free Cash Flow Quick Recap

Free cash flow is the money generated that is not required to maintain operations. Simply, it is money that the business can use for whatever it wants. It can put it in the bank, give it to charity, pay a dividend, buy back shares or use it for future growth.

So when we use the simple version of the FCF formula

FCF = Net Cash from Operations - capital expenditures

we are calculating FCF by subtracting both the capital expenditure that is used to maintain operations and to fuel future growth.

(I am not talking about owner earnings here. Just the textbook FCF definition)

So in order to get an accurate FCF figure, the correct method would be to subtract ONLY the capital expenditure used to maintain the business.

What is Growth and Maintenance Capital Expenditure?

As outlined above, maintenance capex is the money that is required to maintain or replace assets.

e.g. A typically high capex company such as oil drillers are required to service its rigs and replace parts just to stay in business.

Free Cash Flow attempts to differentiate between growth and maintenance but it is rare for companies to disclose what is used for maintenance and growth in their statements, nor is it required. This makes finding maintenance capex a difficult task.

Before I go on, let me say that finding maintenance capex is definitely an art. There is no strict formula or method and I have yet to come across a firm process to date.

If you have know of a better way, please leave a comment at the end.

How to Calculate Maintenance Capital Expenditures

The common method is to assume

Maintenance Cap Ex = Depreciation and Amortization

therefore

Free Cash Flow = Net Cash from Operations - D&A

The train of thought is that buildings and equipment will need to be replaced in the future and because depreciation is usually a straight line approach, it will also be much smoother.

By looking at several years of data, a capex number that is stable yet does not lead to increased revenues is a sign that it is mostly maintenance capex.

Determining Maintenance Cap Ex

Let’s look at the difference between three companies, JNJ, WMT and ATW. I chose these three companies as I figured their capex requirements would vary.

My reasoning is that JNJ should have lower capex since their intellectual property and patents equates to a low maintenance capex, such like MSFT. They also sell their products distribution channels which should also keep the maintenance capex down.

WMT owns and leases their stores, is required to purchase more inventory in their existing stores.

ATW is a heavy growth and capex company as it is a deep sea oil driller which requires an extensive amount of capital and credit for maintenance and growth.

in $mil 2005 2006 2007 2008 JNJ Revenues $ 50,514 $ 53,324 $ 61,095 $ 63,747 D&A $ 2,093 $ 2,177 $ 2,777 $ 2,832 Capex $ 2,632 $ 2,666 $ 2,942 $ 3,066 WMT Revenues $ 312,427 $ 348,650 $ 374,526 $ 405,607 D&A $ 4,717 $ 5,459 $ 6,317 $ 6,739 Capex $ 14,563 $ 15,666 $ 14,937 $ 11,499 ATW Revenues $ 176 $ 276 $ 403 $ 527 D&A $ 27 $ 26 $ 34 $ 25 Capex $ 26 $ 79 $ 91 $ 328

So from the above number what do you see?

Notice how a non capex heavy, stable cash cow business such as JNJ has D&A roughly similar to capex? JNJ has a very steady and minor increment in capex which also leads to a slow yet steady growth in revenues.

WMT is also similar. In 2008 we can estimate that their maintenance capex was $6,739m (D&A) which means that $4,760m was used for growth.

Lastly, we see that ATW has a fairly stable depreciation yet their capex growth is exponential. Now this is a sure sign of investing in growth and if you read and listen to the conference calls, they are building new and better rigs to add to their fleet.

Using depreciation and amortization as maintenance capital expenditure is also useful for when capex is erratic and FCF inconsistent, which is usually the case for companies like ATW and other industrial commodity businesses.

Another alternative is to normalize the capex or free cash flow, whichever is easiest and then used the normalized number as the beginning point to your present value formula in the DCF valuation.

Bruce Greenwald also has a approach which I will get to in another post once I finish reading his book.